Download The Diversified Portfolio Index

The Diversified Portfolio Index ™
By Charles Fahy, Sr.
The Streetwise Investor, Author [Probus, 1992]
Fort Bend Lifestyle Magazine, Columnist [1986-96]
Option Writing Techniques 1974 Prentice-Hall Publishers, Inc.
IRA Rollover Fact Folder 1978 Prentice-Hall Publishers, Inc.
Money Talks, Television Host [Houston, TX 1987-91]
Investment professional since 1972
(281) 507-4637 [Cell]
http://www.unadex.com
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Achieving an investment rate of return, that is merely average but
very consistent, may result in exceptional performance, even if for a
lucky few. Over longer and longer durations, it becomes increasingly
difficult to outperform.
After 40 years of working in Wall Street, absorbing all the data
and information I could consume on the subject of investing, I found
that it did not provide me with the knowledge required to be a
successful long-term investor. The anticipated wisdom from the
acquisition of all this knowledge and data remained elusive. In time,
the en vogue investment styles and asset classes eventually succumb
to mediocrity, or worse, total collapse. Although they post some
successful trades, investors ultimately face a few bad trades, resulting
in very mediocre overall performance. Even picking a series of
securities that work well, an active trader would continue to make
trades until reaching the point where having done nothing would have
been better. Even hindsight could not provide me with a particular
style that would have provided better than average performance for a
standard portfolio. While equities were favored for the long run up to
2000, an investor would yearn to have been in bonds during the poor
stock performance since 2000. The problem of where to be or how to
invest going forward, had remained a mystery to me the longer I was
in the investment business.
Then, I accidently came up with something smart. Past
performance and hindsight revealed the investment strategy on how to
have had a simple asset allocation methodology for an investment
portfolio, which can be used effectively by the common individual
investor going forward. The answer was the Diversified Portfolio
IndexTM (DPITM). The science to this strategy is to own everything - all
asset classes for a standard diversified portfolio. The average growth
rate of the totally diversified portfolio, containing all the investment
asset classes, has the potential to provide a rate of return that I
originally suspected would outperform a less diversified portfolio, most
of the time. After analyzing historical data, it became clear that there
is enormous value to the methodology. While history does not indicate
what may happen in the future, I noticed that the average growth rate
of the standard diversified portfolio produced returns that exceeded
most less diversified portfolios, all of the time. The total calculation is
the sum of all portfolio returns, from the best to the worst. The
average annual performance appeared to be over the 50% percentile
(arithmetic mean is higher than the median), thus outperforming most
of the individual investments in each year. If this portfolio can
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consistently match the average rate of return year after year,
exceptional performance can be realized. This cumulative long-term
result generates superior relative performance, doing better each year,
versus competitors, as time goes on.
If it is to be believed that the investment markets are efficient and
that no one can “beat the markets” in the long run, then one should
simply own all the markets, all five asset classes: U.S. STOCKS,
INTERNATIONAL STOCKS, BONDS, REAL ESTATE, PRECIOUS METALS
AND COMMODITIES. If all markets are represented by a haystack and
you are always trying to find the needles in that haystack to own in a
portfolio, then you should “buy the haystack” in order to own all the
needles. [One thing to realize though is that investing in general has
its risks and each of these asset classes has their own unique set of
risks. It's best that you work with an advisor to ascertain which, if not
all of these asset classes, can work for you in your unique
circumstances.] This is accomplished by first defining an
encompassing diversified asset class, which represents all investment
markets in a standard diversified portfolio allocation, and then
securitizing this diversified class. This has been accomplished with the
creation of the DPI™. This, I believe, is the first “portfolio index” model
that has been created to represent investing in general. The specifics
are detailed in the Methodology Guide for the Diversified Portfolio
Index™. The asset allocation is summarized here.
Asset Allocation of the
Diversified Portfolio Index ™
U.S. Stocks
40%
International Stocks
(ex-U.S., weighted by GDP)
Bonds
(all maturities)
U.S. Real Estate
10%
Precious Metals
5%
Commodities
5%
30%
10%
This hypothetical example of an asset allocation mix is for
illustrative purposes only and does not reflect upon any specific
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investment. Your specific allocation may vary based on your specific
circumstances. It is not possible to invest in this or any market
weighted index.
The merits of this diversified methodology are validated by
timeless truths. For example, it is said that performance is better
accomplished with “time in the markets and not timing the markets.”
Investing is like a Chinese finger trap: the more you move the worse
off you are. Investing is a marathon, not a sprint. The odds of
successful investing are encumbered by the odds against the investor
with a surfeit of variables to overcome. The investor has to find the
right investment advisor that has to pick the right asset classes and
then select the right securities of each of those asset classes. There
just are so many options from which to choose. Some investors may
choose to use stocks, bonds, or cash equivalent investments. Please
understand though, past performance of any of these strategies do not
assure any guarantee that it will be replicated by future performance.
Even if the investor selects a strategy that works for them,
eventually the question becomes, do you change the strategy, thinking
that it is now prudent to do so? Too many of us end up zigging when
we should have zagged. The technology available to individual
investors also provides a misplaced feeling of increased confidence,
rarely justified. The odds of investing successfully are simply reduced
with the increase of disciplines or variables one has to contend with.
Bull markets increase performance thus causing confusion between
luck and skill in portfolio management. Human nature can be our
worst enemy with respect to successful portfolio management. There
is a tendency to become attached to a position and not sell it while it is
trading at a peak, only to see it fall in price. Then, fear sets in and one
might finally sell it at a substantially reduced price, only to see it go up
again. These are constant factors to contend with in investment
management.
The DPI™’s best use is as a tool to weigh the relative performance
of any investment portfolio. Managers of pension funds and large
institutional funds understand well the merits of diversification in all
asset classes and can execute these well-diversified methodologies.
Their tremendous funding allows for purchasing of securities in the full
spectrum of asset classes. The investment manager then assesses
relative performance to a chosen index according to the particular
style of investing being implemented.
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However, the investor is looking at an investment portfolio and
desires to have a metric to compare his or her own portfolio to either
other possible portfolios or to actual portfolios of other investors. “How
is my portfolio doing?” is the obvious question. It is a simple, straightforward question. Unfortunately, the answer has never been simple or
straight-forward. That is, until now. Using the DPI™ as a comparative
“portfolio benchmark” creates an effective reference to answer exactly
this question for both the institutional manager and the individual
investor.
While asset allocation has the potential to create most of a
portfolio’s investment performance results, the DPI™ study of past
performance shows further that with a minimum of adjustments,
better performance can be achieved. It shows that subjective
strategies rarely add value to achieving performance. The net effect of
active management can be measured when comparing actual results
to the DPI™. It would allow even the largest institutional investments
a simple method of measuring the value of their management by
checking their positive or negative deviation from the DPI™. They
could also easily view what the markets would have provided in that
timeframe using a standard diversified portfolio.
The back study results were calculated using Thomson Investment
View 2010 which has 23,342 funds with which to do comparative
performance studies. This data represents real results of the universe
of strategies employed, active and passive, traditional and creative.
There are outliers in each individual year, but true excellence is
revealed by which pulls ahead over the long run. These numbers were
calculated on a best effort basis and are unaudited.
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PERIOD
YRS DPI™
RETURN
2010
2008-2010
1996-2010
2001-2010
1996-2010
1991-2010
1
3
5
10
15
20
13.23%
2.80%
6.05%
5.58%
6.69%
8.11%
FUND
PERCENTILE
RANKING
RANKING
OF 23,342
57.7%
9,884
78.0%
5,131
89.4%
2,469
86.5%
3,140
91.5%
1,963
94.4%
1,300
Comparing the results in cumulative periods yields these percentile
ranking results.
CUMULATIVE PERIODS
FROM 1990-2010
1y
3y











5y
10y
15y
INDIVIDUAL
PERIOD
RETURN
FUND
RANKING
OF 23,342
PERCENTILE
RANKING
20y

 
  
   
13.23%
2.80%
6.05%
5.58%
6.69%
8.11%
9,884
1,721
998
550
222
92
57.7%
92.6%
95.7%
97.6%
99.0%
99.6%
It is possible that in future behavior the various asset classes may not
show the same historical distributions of relative performance of the
separate asset classes. This accounts for the concern that perhaps the
advantage was due to the fact that the last twenty years saw an ideal
stock market in the first ten years of the study followed by another ten
years of an optimum bond market. Of course, this also implies that the
reverse is true. This means that DPI™ performance was high during a
decade of poor bond market performance followed by another decade
of poor stock market performance. In my opinion, it is not the
performance, per se, as much as the consistency of performance that
produces a true advantage.
It is not only the average of the annual returns that matter.
Strategies may vary from each other year to year but still have the
same average annual return. Intuitively, the end result should be that
they both produce the same total return, but this is not actually true.
The investment with the higher volatility, meaning a greater range of
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individual annual returns, will produce a lower total return over the
same period than an investment with lower volatility. This is crucial to
real success in investment management.
The DPI™ methodology of a fixed allocation across all markets is
designed to achieve better performance when compared to other
known strategies. Note that annual rebalancing keeps the asset
allocation within tolerance, while seeking to minimize performance
drag induced by trade activity.
I believe that individual investors would be well-served to become
familiar with the DPI™. It is a basis to formulate a personal portfolio
methodology and compare the results to the investable universe to see
if the strategy is adding value. The investor gains a better
understanding of portfolio asset management. Comparison to the
DPI™ determines whether it is just transient luck that has allowed you
to catch a seasonal trend.
You must also choose your entry point and exit point. Countering
this issue remains difficult to accomplish. For example, if from March
1997 to March 2002 one remained fully invested in most of the stocks
from the S&P 500, one would have tracked a 10% rate of return.
However, if the best ten days of the market where missed, there is
almost a 90% loss of return, leaving only 1.07%. This shows again
that it is time in the market, not timing the market, which adds value.
The timeless wisdom of investing is encompassed in the
Diversified Portfolio Index™ Benchmark. We are aware of the Efficient
Market Hypothesis by Eugene Fama, the asset allocation study by
Harry Markowitz and William Sharpe, A Random Walk On Wall Street
by Burton Malkiel and more recently the writings of Nassim Nicholas
Taleb in his books The Black Swan and Fooled by Randomness. All of
these works value the theme of diversification.
Diversification can add a stabilizing effect to portfolio performance,
where the value of consistency of performance is more important over
time than trying to seek superior returns by speculating which asset
class will outperform another over shorter periods of time. Instead of
trying to find the needles in the haystack, one can use the uniqueness
of the DPI™ methodology to capture the entire haystack. Own all the
markets, all of the time. By doing so, you increase the total returns
over time.
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However, remember that no strategy, including asset allocation and
diversified portfolio, does not ensure profit or guarantee against loss or
market risk. There is no guarantee that these strategies will enhance
overall returns or outperform a less finely allocated or diversified
portfolio.
Investing in mutual funds are subject to the risks of their
underlying investment holdings including possible loss of
principle. Investments in specialized industry sectors have
additional risks, which are outlined in the prospectus.
Generally, among asset classes, stocks may present more short-term
risk and volatility than bonds or short-term instruments.
Bonds generally present less short-term risk and volatility than stocks,
but bonds contain interest rate risk issuer default risk and inflation
risk.
Foreign investments, especially those in emerging markets, involve
greater risk and may offer greater potential return than U.S.
investments.
The fast price swings of commodities and precious metal investments
will result in significant volatility in investors’ holdings. They are
highly speculative investments and therefore should not represent any
significant portion of a clients’ portfolio.
Investing in real estate/REITS involves special risks such as potential
illiquidity and property devaluation based on adverse economic and
real estate market conditions, and may not be suitable for all
investors. There is no assurance that the investment objectives of the
program will be attained.
Using an analogy of the investment tree to represent the investment
choices, an investor can choose from to formulate a portfolio; one can
look at the growth rate of individual leaves to represent securities and
branches representing segments of asset classes. The trunk represents
the culmination of all possible investment choices, which is best
represented by the DPI™. In time, which leaves or branches of
investing survive the test of time and will grow the most is capricious
and always in doubt. The trunk on the other hand will almost always
be steadily growing. That growth rate encompasses the average
growth rates of all the leaves and branches offered by the choices of
the investment tree.
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For the common investor, human nature must be overcome in
order to potentially increase performance results. While attempting to
succeed in the investment arena, natural behavior can be an investor’s
worst attribute. There is a pervasive feeling that once you buy a
security, it goes down and once you sell it, it then goes up. The DPI™
eliminates the human folly of trying to time the markets and the
insidious human tendency of buying on hot trends and selling low
when all looks gloomy. There is the old adage that “nothing looks
better than a market about to go down or looks worse than when the
markets are about to go up.” The markets mimic that it is often
darkest before dawn. I believe that investors would be well served to
avoid letting this routinely affect investing behavior. On the other
hand, the annual rebalancing mechanism to objectively reset the asset
allocation to the DPI™ standard helps the index to stay the course.
The probability that humans will err with their investment decisions
over a lifetime of investing outweighs their judgment on how to
actively invest successfully. Therefore, performance is better served
with passive asset allocation and a simple rebalancing system. It is,
after all, from the investor’s perspective that it is “performance,
performance, performance and that all else are excuses.” The
academics are correct, the market is efficient yet random [Burton
Malkeil and Harry Markowitz], and much more is attributable to luck
than we care to admit [Nassim Nicholas Taleb]. Accomplishing an
average yearly return each year in your investment portfolio is indeed
a very difficult and rare accomplishment.
All rights reserved.
© 2011 Charles Fahy, Sr. All rights reserved.
This document and its content are copyright of Charles Fahy. Any redistribution or reproduction, by any means, of all
or part of the contents in any form is prohibited without the permission of Charles Fahy. Except with his express
written permission, it is prohibited to distribute or commercially exploit the content.
“Diversified Portfolio Index”, “DPI”, “Unadex LLC” and “Unadex” are trademarks of Unadex LLC.
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Contact Unadex LLC – http://www.unadex.com
For information on DPI licensing, please contact:
Charles L. Fahy, Jr.
Managing-Member
Unadex LLC
4900 East Oltorf Street #1138
Austin, TX 78741-7649
Also available for further information:
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Managing-Member
Unadex LLC
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Houston, TX 77057
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